QS Study

Importance of Liquidity and Profitability in commercial banking

Liquidity ensures short-term survival. Profitability ensures long-term survival. Both are essential for any company to survive. In the context of an asset, Liquidity implies convertibility of the same ultimately into Cash and it has two dimensions in it, viz., time and risk. Profitability of a firm is represented by the rate of return on its capital employed.

Liquidity measures the ease at which a business can meet its immediate and short-term financial obligations. Profitability is a measure of business success. It ensures the financial sustainability of the business and gives the business the capacity to endure.

The liquidity is normally measured with the help of the following financial ratios: (a) Current Ratio; (b) Liquid Ratio; and (c) Absolute Liquidity Ratio.

Liquidity for a bank is primarily influenced by how much assets (loans & investment in treasury bills) it has, how much liabilities (deposits), it has, and how much reserves it keeps. Low liquidity means that it would not be able to withstand a run on the bank. If a bank is unprofitable, most like due to loan losses or lawsuits, it will impact the liquidity of the bank. Even with healthy liquidity, no company can have sustained losses over a long period of time. The lower the liquidity ratio, the greater the chance the company is, or may soon be, suffering financial difficulty. A company needs financial liberty of accomplishment. This means you must be capable to reimburse your bills. If you cannot pay, you’re insolvent, also called bankrupt. To evade this situation, which often spells the end of a company, and stay put solvent to pay your bills, liquid funds are a requirement.

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